Risk & Economy » Brexit » A benign Brexit deal could turn headwinds into tailwinds

For three years, the news in the UK has been dominated by Brexit. Following the triggering of Article 50 of the Lisbon Treaty, the date at which Britain was due to leave the EU was 29 March, 2019. This has come and gone, and a series of extensions have been put in place. The saga, and the uncertainty, continues.

In the first few months after the referendum, British manufacturing was given a boost as a consequence of the fall in the exchange rate. The pound was valued at $1.48 immediately before the referendum and collapsed immediately to $1.30, falling further over the subsequent three months before staging a (very) partial recovery. The level of exports rose in response to this depreciation, and, for the first year after the referendum, this meant that the rate of growth of exports – and also of manufacturing output – was stimulated. As was to be expected, this stimulus to growth was a one-shot event. Over the more recent period, growth has been much more modest.

Indeed, several studies using a variety of different methods of estimation, confirm that, over the last couple of years, growth of the UK economy has been around 1.5% slower than it would have been in the absence of the decision to leave the EU. The cumulative effect amounts to almost £1 billion per week in lost output.  The economic forecasts of the Office for Budget Responsibility – the official forecasts upon which the government bases its Budget – expects real GDP to grow at an annual rate of – at most – 1.6% in each of the next five years, and that assumes a relatively benign form of Brexit. By historical standards, that represents truly appalling performance.

The economic damage we have already seen is due in no small part to the continued uncertainty. Weeks after the 29 March deadline, businesses in the UK still do not know whether Brexit will be hard or soft. Indeed, they do not know when it will happen, or even if it will happen at all.

This uncertainty has had profound and damaging effects. The annual rate of growth of business investment has averaged just 0.7% in the ten quarters for which data are available since the referendum, while in the preceding ten quarters it averaged 3.3%. In the second half of last year, it turned negative, and by the end of 2018 business investment was falling at a rate of more than 2.5% per year. Measures of business confidence in recent months have also been falling, particularly in the services sector, and this seems to be linked to the continued uncertainty surrounding Brexit.

At industry level, over the past year there have been particularly large falls in business investment in chemicals, food, drink and tobacco, and other manufacturing. In the vehicles and engineering sector, there has been a modest increase of just 1%. Meanwhile, in services there has been a particularly large fall in business investment in the distribution industry, which, given the travails of the high street, is facing a double whammy.

Real world economics

All of this matters. Investment in equipment tools people up to do their work, and a lack of investment heralds a slowdown in labour productivity. The adverse effect on real wages – already squeezed by a decade of austerity, and still 6.7% below the pre-recession peak – is likely to be felt for years to come. This is likely to feed through into lower levels of demand that may prove to be long lasting.

The dip in investment in big manufacturing is a particular concern. There have been several announcements of major job cuts in the motor vehicle industry, including at Nissan, Honda, JLR, Ford and Toyota. In common with the retail industry, there are factors specific to the car industry that underpin these developments. In particular, the decline in demand from congested China and the switch in preferences away from diesel are both having adverse effects. But Brexit is undeniably another contributory factor.

Under a hard Brexit, the motor vehicle industry would be particularly hard hit. The EU tariff on cars, at 10%, would make it difficult for UK exports in this industry to compete. Moreover, supply chains in the vehicles sector are complex and straddle national boundaries within the EU. With their just-in-time production technologies, the options for car producers are either to increase their stocks of parts – a costly exercise which would again make their product less competitive in the marketplace – or to consider relocating at least some of their production. Little wonder that many are seeking to keep their options open, and so holding back on major investment decisions.

Other high-tech manufacturing sectors are likewise considering their options. Airbus, for example, has estimated that it could lose up to Euro1bn a week if its supply chains were severely disrupted by a no deal Brexit – and, although it does not anticipate a sudden switch of production out of the UK, it is clearly considering its longer-term position.

In the services, the importance of the finance sector to the UK is hard to overestimate. At one stage, a major exodus of firms from this sector was feared, but it now appears that many have coped with smaller reorganisations that will allow them to continue trading in the EU. Nevertheless, the Financial Conduct Authority recently warned that many firms in the sector remain underprepared for the possibility of a no deal Brexit.

With all this as context, it is no surprise business organisations such as the Institute of Directors and the  CBI have been vocal in urging both an end to the uncertainty and the need to avoid a no deal outcome. The government has likewise been keen to avoid a no deal outcome. Its own calculations suggest that such a result would have an extremely deleterious impact on the UK economy, with GDP under this scenario being some 9.3% lower than it would otherwise be in 15 years’ time – a figure that is unsurprising given the collapse of demand for UK exports to the EU that would necessarily result from the EU’s enforced imposition of tariffs in line with WTO ‘most favoured nation’ rules. Avoiding no deal, however, requires a deal, and getting to a place where there is political agreement on a deal has proved difficult.

While uncertainty remains part of the terrain, and while the odds on any particular outcome change daily, it does now seem likely that a deal will be struck. The political declaration is aspirational, but it provides some important signposts. Importantly it promises the absence of tariffs between the UK and EU. It refers to ‘deep regulatory and customs cooperation’, and this implies that in many areas the UK will aspire to remain close to the single market. All of this should facilitate trade. Representatives of business involved in the development of any independent regulations for the UK will need to weigh up carefully the balance of costs and benefits in diverging from single market rules. To this extent, at least, the impact of any divergence from such rules would be in the hands of British business itself.

Once the political and economic environments in the UK become clearer, the appetite for business investment should gradually improve. The unpromising forecasts for GDP growth over the next half decade suggest that the UK nevertheless faces headwinds. A relatively benign Brexit and greater certainty should help business not only cope with those winds, but help turn them around to the tail.